Chapter 17

Economic Growth
Is Economic Growth and Environmental Quality Connected?

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 Learning Objectives

1. Learn how to calculate economic growth

2. Understand why small differences in growth rates lead to large
differences in living standards over time
3. Understand why GDP per capita can be approximated by the
product of average labor productivity and the proportion of the
population that is employed
4. Discuss the determinants of average labor productivity
5. Discuss and evaluate government policies that promote
economic growth
6. Understand the trade-offs between growth and environmental
quality
7. Understand how the property of diminishing returns and the
catch effect are related to economic growth.
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 Real GDP per Capita

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 How Do We Measure Standard of
Living?

 The standard of living is measured by real GDP per person

(RGDP/population). High (low) real GDP per person
indicates high (low) standard of living.

 In order for the standard of living to be increasing over time,

the economic growth rate (%∆RGDP) must be higher than the
population growth rate (%∆POP); that is, %∆RGDP >
%∆POP. In other words, in order for the standard of living to
be increasing over time, the economy must be growing faster
than the population. Note that, %∆(RGDP/POP) =
%∆RGDP - %∆POP.
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 Example: The data for the Jordanian economy on RGDP (in millions
of Dinars in 1994 prices) and population (in millions of people) for
1994 -1998 are:

Year RGDP POP (RGDP/POP) %∆RGDP %∆POP %∆(RGDP/POP)

1994 4,391.6 5.51
1995 4,560.8 5.73
1996 4,605.1 5.94
1997 4,665.8 6.13
1998 4,769.8 6.30

1. Calculate the standard of living. Did the standard of living

increase over time?
2. Calculate how fast the economy (or real GDP) was growing.
3. Calculate how fast the population was growing.
4. Calculate how fast the standard of living was changing
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 Why “Small” Differences in
Growth Rates Matter

 Growth rates do not really differ by much

among countries, look at previous table.
 Highest growth rate is 2.51 percent (Japan) and
lowest rate is 1.27 percent (Egypt) (1870-2008).
 However, consider the long-run effect of this
seemingly “small” difference in terms of GDP
per person. In Japan, GDP per person in 2008
was $22,816 while in Egypt, it was $3,725.-
 This is from the power of compounding, often
illustrated by compound interest.
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 Why “Small” Differences in
Growth Rates Matter

 Compound interest pays interest on the original

deposit and all previously accumulated interest
 Interest paid in year 1 earns interest in year 2
 $10 deposited at 4% interest in 1800 is $31,033.77
in 2005
 $10 x (1.04)205 = $31,033.77, which comes
from:
 FV = PV (1 + i)n

 RGDP(Future) = RGDP(Present)(1 + g) n

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 How Long Will it Take
for Income to Double?
 According to the rule of 70, if some variable grows at a
rate of x percent per year, then that variable doubles in
approximately 70/x years. If the UAE economy grows at 3
percent per year, then it takes about 70/3 = 23 years for
income in the UAE to double. If the UAE economy grows
at 1 percent per year, it takes 70/1 = 70 years for income in
the UAE to double, huge difference!

 The rule of 70 applies not only to a growing economy but

also to a growing savings account. Assume that you have
50,000 dirhams in your savings account that pays 5%
interest annually. You 50,000 dirhams will double in about
70/5 = 14 years.
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Why Nations Become Rich: The Crucial Role
of Average Labor Productivity

 What determines a nation’s economic growth

rate?
 To get some insight into this question, we express
real GDP per person as the product of two terms:
 Average labor productivity
 Share of the population that is working
 Assume the following notation
Y= real GDP
 N = number of people employed
 POP = population

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 Real GDP per Capita

 In other words,

Real GDP per person = Average labor productivity × Share of population

employed

 This expression tells us something very basic and intuitive: The

quantity of goods and services that the economy produces depends
on:
 How much each worker produces and
 The share of people working

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 Understanding Growth

In the long run,

increases in GDP per person
arise primarily from
increases in average labor productivity

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 The Determinants of Average Labor
Productivity

 US average labor productivity is

 24 times Indonesia's
 100 times Bangladesh's

 Five factors determine average labor productivity

1. Human capital
2. Physical capital
3. Natural resources
4. Technology
5. Political and legal environment

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 Economic Growth
and Public Policy
 So far, we have determined that a society’s
standard of living depends on its ability to produce
goods and services and that its productivity
depends on physical capital, human capital,
natural resources, entrepreneurship, technological
knowledge, and political environment.
 What can government policy do to raise
productivity and living standards?

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 The Role of Property Rights and
Political Stability
 Policy makers can foster economic growth by protecting
property rights and promoting political stability.
 Property rights are key for the promotion of savings,
investments, education, research and development, and
trade.
 Property rights refer to the ability people have to exercise
authority over the resources they own. These resources
could be physical or intellectual.
 When revolution and coups are common (political
instability), there is doubt about whether property rights
will be respected. Consequently, rising productivity and
living standards become difficult.
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 Promote Saving and Investment

 The growth that arises from capital accumulation

(investment) is not a free lunch. It requires that
society sacrifice consumption of goods and
services in the present (savings) in order to enjoy
higher consumption in the future.
 Savings are the source for investment funds.

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Promote Investment from Abroad

 Domestic investment can be complemented

with investment by foreigners.
 A foreign direct investment (FDI) is capital
investment that is owned and operated by a
foreign entity in a country other than its
own.

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 Promote Education

 Education is investment in human capital, is at

least as important as investment in physical
capital.
 In western countries each year of schooling rises a
person’s wage on average by about 10%.
 In less developed countries where human capital is
especially scarce, the wage gap between educated
and non-educated workers is even larger.

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 Promote Research and
Development
 The primary reason that living standards are
higher today than they were a century ago is that
technological knowledge has advanced.
 Governments must encourage research and
development of new ideas.

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 Promote Free Trade

 Some of the world’s poorest countries have tried to

achieve more rapid economic growth by pursuing inward-
oriented policies.
 Inward-oriented policies are aimed at raising productivity
and living standards within the country by avoiding
interaction with the rest of the world.
 Most economists today believe that poor countries are
better off pursuing outward-oriented policies that
integrates these countries into the world economy.

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 The Environmental Kuznets Curve

 Does economic growth takes place

at the expense of the environment?
 Research seems to indicates that
pollution increases up to a point with
increased GDP per person A
 After A, air pollution decreases and air

Air pollution
quality improves
 Beyond a certain level of income,
citizens value a cleaner
environment and they are willing Real GDP per capita
and able to pay for it
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Important Properties Related to Economic Growth:
Diminishing Returns and the Catch-up Effect

 Diminishing returns is the property where by the

benefit from an extra unit of an input declines as
the quantity of the input increases, keeping all
other inputs constant. Economic growth cannot
take place if countries concentrate on developing a
single input (more educated people, for example).
 Catch-up effect is the property where by countries
that start off poor tend to grow more rapidly that
countries that start off rich.

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